The monetary show in Japan is getting so fascinating to me it’s starting to compete with my viewing of the Stanley Cup Playoffs at night. Prime Minister Abe has inspired a stock market surge of about 80% over the past six months and a run up in interest rates of about 60% over the past six weeks via monetary policy that’s more aggressive than anything the world has ever seen. He’s literally scared investors out of bonds and into stocks by threatening to drastically debase the currency, which he has accomplished to the tune of 25% over the past six months, as well.
Central banks around the world have been competing for months to see who can be the most accommodative. It seems the Bank of Japan has attempted to “shoot the moon.” Nobody really knows how these experiments that the central bankers have been performing will work out but the process has been accelerated by the recent developments in Japan. And, as card players well know, “shooting the moon” is not without risk.
The first flaw in Abe’s hand showed up this week when the Nikkei index plunged 7% in a single trading day. The kind of volatility we’re now seeing in Japanese stocks and bonds doesn’t usually resolve itself without some significant pain. As Bill Fleckenstein suggested a couple of weeks ago there are large portfolios of derivative instruments around the world that have relied on ultra-low rates in Japan as a major part of their overall investment thesis. The rapid run up in rates could cause some major problems reminiscent of those that popped up during the financial crisis.
A long-term look at the Nikkei (thanks to Chris Kimble) shows it running into very important resistance, resistance that has setup declines of 30-60% in the past. In addition, most of the investors in Japanese stocks have recently been foreigners or what Kyle Bass refers to as “macro tourists,” amateur investors venturing outside the circle of competence to speculate in macro trading. How much confidence do they have in Abe’s ability to levitate the Nikkei even further? I’m sure we’ll soon find out.
What’s Ben Got Up His Sleeve?
I find it very curious that just as Japan has gotten more aggressive the Fed has backed away from its unprecedented monetary easing. Through various channels Bernanke has made it clear that the Fed is looking to reduce its $85 billion-per-month of asset purchases.
Economic statistics have not improved to any meaningful degree nor has unemployment so why would the Fed even consider reducing these programs? My guess is that they are starting to worry about getting trapped into QE infinity and simply want to put a finger in the wind.
The markets and the economy are doing well today (the former better than the latter, of course). But if one or both were to reverse meaningfully (recessions historically occur every 5 years on average; it’s been 4 since our last) while the Fed was still pursuing the most aggressive policy in its history it could cause a few problems.
For example, this sort of situation may induce them to ramp up these programs further, above and beyond the $1 trillion in asset purchases every year they already make. In this case, investors may begin to question if these programs really benefit the economy or the markets at all. Or even if they do work how bad is the situation really if $1 trillion of money printing is not enough to save us?
I’ve written before that this whole thing is merely a “confidence game.” So long as investors believe Bernanke has the ability to support the economy and the markets everything is hunky dory. However, should investors have cause to lose faith things could get pretty nasty in the financial markets once again.
So far Bernanke has played this game marvelously. But the game gets more precarious and the stakes get higher and higher every day.
For the record, I “turned bearish” about three months ago and stocks have rallied almost 10% since. Clearly, I was too conservative; okay, I was wrong. There – I said it. But I’m not sorry because I haven’t bet against this rally by hedging or going short (that and I’ve been bullish for the past four years). As I wrote at the time I merely began to reduce exposure to stocks.
Now if my stated goal was relative returns then I would certainly feel more contrite. Unlike the vast majority of investment managers, however, I manage the capital in my care to generate absolute returns. This means I only take on risks when the potential reward justifies it and I reduce risk when the probability of generating profits is significantly diminished.
This sort of thinking appeals to most people most of the time in the real world. “Better safe than sorry,” “don’t put all your eggs in one basket,” “a bird in the hand is worth two in the bush,” are all popular sayings because they save us from unneeded hardship in our lives. So prudent people employ this kind of thinking on a daily basis… but, curiously, not when it comes to investing their money.
The fact that 99% of professional money managers pursue relative rather than absolute returns demonstrates that it’s not just individual investors but the pros, too, who have abandoned common sense and reason when it comes to the investment game. How else do you explain being fully invested in the stock market in 2000, 2007 or today?
The only explanation I can come up with is that both professional and investors have abandoned the common sense thinking like that expressed in the aphorisms above along with basic investment analysis that suggests the risk/reward equation for stocks at current prices is very unattractive (along with basic macro analysis, see above).
So I will underperform during periods like these but I won’t be sorry for adhering to an investment discipline that keeps me out of stocks during times like these. Because it also helps me avoid the inevitably painful resolution, as well. It will also give me the confidence to take advantage of the next time stocks become undervalued – because it’s only a matter of time.